Laguna State Polytechnic UniversitySta. Cruz Main Campus

Sta. Cruz, Laguna

Subject: MAJOR 7 (Microeconomics/Macroeconomics)Topic: Monetary Policy and Fiscal PolicyDiscussant: Antonio, Rose Anne P.

Calaylay, Eddelyn Jessica S.Dorado, Paolo F.Encarnacion, Mirabeth J.Quijaro, Jamaica F.Surbano, Cristell D.Untivero, Lemuel B.BSED III-C (Soc. Sci.)

Professor: Prof. Josefina T. De Jesus

THE NATURE OF ECONOMIC POLICIESAn economic policy is based on economic theory or principle. It is the application of a

theory or principle. Economic policies are formulated to attain specific objectives or solve certain problems.

An economic theory is derived from facts. Data are gathered and presented for analysis. Out of this process, a theory is produced. However, in the case of economic policies, it is no longer possible to depend only on facts. Policy makers are people with various values, orientations and interests. Many policy makers are politicians or top government officials who have been elected by the people. In most cases, they are inclined to make policies which ensure their re-election or matters of political expediency rather than economic interests. Thus value judgments interact with facts. Obviously, the values of the policy makers greatly influence the policies that they make.

In cases where the policy makers are not politicians, the effects are just the same. Technocrats are appointed by top government officials who are politicians. Naturally, such elected officials influence the decisions of their technocrats. Of course those who have principles and conscience can resign, if there are conflicts of interest or values.

Therefore, economic policies are as good as their makers. If the policy-makers are only after their own personal interests and that their friends and relatives, then their policies have little effects or adverse effects on other sectors of the economy. In some cases, there are good policies but these have not been implemented or poorly implemented.

WHAT IS A GOOD ECONOMIC POLICY?

- It must be stated in broad terms.- It must be long range, but flexible to a certain degree.- It must be in writing and easy to understand.- It must be widely acceptable.- It must be reasonable.- It must be consistent with the objectives and goal to be attained.- It must be communicated to all concerned.- It must be implementable.- It must cover all important relevant aspects.- It must be in accordance with the law.

Nevertheless, the most important element of a good economic policy is its deep concern for the welfare of the people, especially the poorest of the poor. Precisely, it is this group – which is the largest group in the less developed countries – that needs most the benefits of a good policy. For one reason or another, some good economic policies remain unimplemented. The interest of a few but powerful groups appears to dominate other more important considerations.

PEOPLE-ORIENTED POLICY

A good economic policy should be people-oriented. The welfare of the people is always the primary consideration. Some former poor nations became progressive because their policies have been focused on the improvement of the quality of life of the masses. Japan is one good example. Even the business corporations of said country fashion their policies towards human resource development. To them their employees are the most important assets. They take good care of their employees. Such paternalistic attitude of corporate institutions have made employees happy and efficient.

In the Philippines, it has been proclaimed that the main program of the government is to improve the quality of life of the people. In fact, the Six Year Development Plan (1987-1992) is a multi-pronged human development approach. Dr. Placido Mapa, Jr., former Minister of Economic Planning said:

Man has always been the focus of all development efforts; hence, the ultimate goal of all development activities is to improve the people’s quality of life. This brings us to a point: that of sharing the fruits of development. And this goal can only be achieved by pursuing national development policies for various regions, through which the government hopes to redress income disparities caused by growth imbalances.

OBJECTIVES OF ECONOMIC POLICIES

Economic policies are broad rules or guides for actions. They are made for the administration of a project, program or the whole economy. The most important economic objectives of any democratic society are:

1. Economic growth2. Full employment3. Economic freedom4. Equitable distribution of wealth and income5. Economic security6. Economic stability

To attain such economic objectives, appropriate policies are needed. However, this is easier said than done. Policy makers are human beings with various orientations and values. Whether they like it or not, these influence the substance and form of the policies that they formulate. For instance, the concept of equitable distribution of wealth and income has varied interpretations. The same is true with the other economic objectives, especially economic freedom. How far and how wide should economic freedom be? This is debatable and it all depends on the values and orientations of the policy makers. Policy makers have their own vested interest to protect – including those of their relatives and friends. All these came into play with their competence. However, competence and intelligence are not enough qualities of good policy makers. Above all, they must have integrity and honesty.

Another problem in policy making is that some economic objectives are interdependent while others are conflicting. For interdependent objectives, focus of policies should be on the key objective. The linkage effects help the attainment of the other objective. This is a wise use of scarce resources. In the case of conflicting ones, compromises have to be made. For instance, in achieving a certain rate of economic growth, inflation is likely to crop up. This means disturbance of economic stability. Since inflation cannot be totally removed during the process of economic growth, there is a need to strike a happy balance between economic growth and economic stability. Clearly, this is not an easy task for policy makers.

MONETARY POLICY

Professor James Boughton of Indiana University defined monetary policy as the process whereby the monetary authority attempts to achieve a desired set of economic goals by controlling either the money policy, the cost and availability of credit or the allocation of credit to its various uses. Monetary policy-making body of the government is the Monetary Board headed by the Central Bank governor. The Bangko Sentral ng Pilipinas is responsible for implementing the monetary policies formulated by the members of the Monetary Board. The primary monetary goals of the Bangko Sentral ng Pilipinas are:

1. To maintain internal and external monetary stability in the Philippines and to preserve the international value of the peso and its convertibility into other freely convertible currencies; and

2. To foster monetary, credit and exchange conditions favourable to a balanced and sustainable growth of the economy.

Major Monetary Tools

- Legal reserve requirements – increase or decrease of the percentage of reserve deposits of banks as required by the Central Bank.

- Open-market operations – purchases and sales of government securities by the Central Bank.

- Moral suasion – appeal of the Central Bank to the banks to expand or contract their credit or to suspend types of bank credit.

The aforementioned monetary tools can either expand or contract money supply to suit the needs or conditions of the economy. For instance, if there is inflation, the policy is to contract money supply by increasing the reserve requirements, selling government securities, and by appealing to the banks to control their loans. This is a tight money policy. On the other hand, if the economy needs an expansion of the money supply, a reverse monetary policy is adopted.

IDEAS ON MONETARY POLICY

The Keynesians, led by Samuelson, Tobin and Heller, believe that a free enterprise economy has several inherent limitations. For example, it does not provide social goods, it does not properly allocate resources, and it leads to the unfair distribution of income. Furthermore, a free enterprise economy or capitalism cannot balance investments and savings. Thus, business fluctuations are created and this is not good to the economy.

The followers of John Meynard Keynes consider the active role of the government in stabilizing economic activities. This is fiscal policy which refers to government expenditures,

taxation, and borrowings. They believe such government activities or fiscal tools are better than monetary tools in achieving economic stability, resource allocation, and income distribution. Professor Paul Wonnacott of the University of Maryland stated that Keynesian economics underestimates the role of monetary policy in stimulating aggregate demand and that the Keynesian theory stresses the instability of private markets.

FREE MARKET SYSTEM IS BETTER

On the other hand, the monetarists, headed by Milton Friedman challenged the Keynesian concepts. They believe a free enterprise economy or laissez fare is better for the whole economy. This is also what the classical economists under Adam Smith developed during the later part of 1700’s. They stressed that free competition automatically distributes resources efficiently. Through free market mechanism, goods and services are better allocated than through government agencies or interference in the market system.

The Monetarist claim that the government decision-making process is bureaucratic, inefficient, and harmful to individual incentives – not to mention the frequent blunders of government policies. Likewise, the centralized decisions of the government destroy individual freedoms. To the monetarists, monetary policy is the key determinant of aggregate demand. Through the role of money and price, level of economic activities can be determined. And these strive better in an environment of free enterprise economy or free market economy. Believers of free enterprise emphasize the importance of natural liberty in the economy. If individuals are free to seek their own interests through competitions, they believe this will promote the interests if the whole society.

ROLE OF MONEY SUPPLY

Another area of conflict between the Keynesians and Monetarists is the role of money supply in producing changes in the level of national income. The Keynesian economists believe that monetary policy has an indirect effect on national income by causing changes in the interest rate which in turn changes consumption and investments. On the other hand, the Monetarists argue that changes in the money supply have direct effects on the national income. In addition, they claim that stable prices and a steady growth rate of the GNP. In contrast, the Keynesians believe that monetary policy can successfully keep the economy on steady growth with low unemployment only when it is combined with appropriate fiscal policies.

SHORTCOMINGS OF MONETARY POLICY

When a monetary or financial problem or need emerges, monetary authorities have to confirm it by gathering facts. These have to be presented and analyzed in order to be able to formulate sound and appropriate monetary policies. The whole process takes time, and even

longer for the less developed countries with inefficient public administration. Another delay is the impact lag which is the time between the implementation of the monetary policy and the different sectors of the economy. In view of the conflicting interests of the different groups in the economy, it is not easy to evaluate the effects of monetary policies.

Furthermore, a monetary policy is a very weak during deep depression. Even if banks offer the lowest possible interest rate to investors, still there are no takers because the expected returns to investors, still there are no takers because the expected returns of investment are even lower than the interest rate. As a good example, during the Great Depression in the United States in 1930’s, monetary policies miserably failed to accomplish their missions.

OTHER LIMITATIONS

Professor Michael Todaro criticized the ability of the Third World countries to regulate money supply and interest rates. He observed that the developed countries like the United States and those in Western Europe have well-organized and efficient money and credit markets. It is therefore possible for such countries to regulate their money supply and interest rates to suit the needs of their economies. This is not the case in most less developed countries. Their money markets and credit institutions are unorganized and fragmented. This makes the administration of monetary policies less effective.

Prof. Todaro further noted that many commercial banks in the developing countries are branches of big banking institutions in highly developed countries like United States, Great Britain, France and Canada. Naturally, such branches of foreign banks are more interested in the monetary policies of their own countries than the local policies.

The ability of the Third World governments is further limited by their dependence on foreign exchange earnings like dollars. As a source of local financial resources, such earnings are unpredictable and uncontrollable. For instance, a considerable decline in demand for or decrease in the prices of our agricultural products in the world market has major adverse effects on our monetary condition. This decreases national income and foreign exchange earnings. Dollars are very important because we need these to buy our oil and raw materials for our factories and industries. We need also dollars to purchase machines for economic development.

Moreover, Todaro gave his negative impressions on the dual monetary system of most less developed countries. That is one for the rich and another for the poor. However, the system tends to serve more the needs of the wealthy groups who are considered safe borrowers. These are the foreigners and the well-known local elite. Thus, the poor – which is

the biggest group – are neglected. As a result, they seek loans from unlicensed money lenders who usually demand very high interest. The more they become miserable.

UNIVERSAL BANKING

The Philippines has adopted the concept of expanded commercial banking which is a variation of the German model or universal banking. This allows the banks to expand their function as so as to become superbanks with department store capabilities. Under this scheme, commercial banks are allowed to engage in non-banking activities, whether these are allied or not to banking. Expanded commercial banking is expected to promote healthy competition, achieve greater efficiency, and provide long-term lending.

The economy has experienced that despite the remarkable growth of the financial system, accumulated earnings were not enough to supply the credit needs of the economy. The financial system failed to provide adequate medium and ling-term finance. It has been observed that heavy reliance on short-term finance created a climate of uncertainty for investors and reduced capital formation.

Furthermore, the present financial system favoured misallocation of existing financial intermediation. Hence, the need for changing our financial system. It should be responsive to the changing and growing needs of the economy. With the adoption of universal banking, the financial system will be in a better position to help the growth of the economy. There will be an expansion in the local and international banking operations. And this will create a more favorable climate for both domestic and foreign investments. Likewise, an increase in the flow of funds into productive projects may be expected to support the industrialization and export promotion program of the country.

FISCAL POLICY

Fiscal policy is another major economic policy. It refers to the revenue and expenditure measures of the public budget. Fiscal policy-making involves the voters, the president and his cabinet, and the legislative body. In a democratic society, the needs and wishes of the people are reflected in the budget. These are prioritized based on available resource. For example, the felt need for a public elementary school in a barrio in Palawan or an irrigation system in Tayug, Pangasinan is included in the budget. This is not only social or economic reason but also for political reason. In most cases, political interests appear more dominant. Usually, such projects are given to the people when elections are near.

Preparation of the budget is done by the president and his cabinet. The budget proposal is submitted to the legislative body for discussion and decision. The task of administering the budget belongs to the President and his cabinet.

As stated earlier, the monetarists and the classical economists believe that the free market system is the best way to allocate the resources of society. Such idea is not completely correct. There are market imperfections such as the inadequate market knowledge of both sellers and buyers, obstacles to free entry in the market, and the unfair business practices. Because of these the interests of the consumers should not be left to the invisible hand of the free market forces of demand and supply. Otherwise, buyers would experience several forms of exploitations like overpricing, adulterated products, tampered weights and measurements, etc.

PROVISIONS OF SOCIAL GOODS

The free market mechanism cannot perform effectively all economic functions. A government policy is needed to guide, correct, and supplement it. Actually, there is one area in which the free market mechanism hesitates to engage in. This is the provision of social goods like anti-pollution projects, roads and bridges that are not heavily used and other social infrastructures which do not yield good profits.

Social goods generally incur huge investment of funds, and yet many of them are not profitable. Thus the private business sector does not want to undertake such activities. This is only understandable. Businessmen do business or put up factories for profit. For instance, constructing a long road in a mountain village is not a sound business project. However, there are exceptions like the North Diversion Road and the South Superhighway. It appears that these two projects are good investments for CDCP.

Since the government is for service and not for profit, it can construct roads, bridges, and other projects like communication facilities, electrification and huge irrigation dams. Anyway the funds come from the people in the form of taxes. Such socio-economic infrastructures are set up not only to serve the needs of the people but also to help the private business sector. When transportation and communication facilities are adequate and efficient, trade and commerce grow faster.

It is clear therefore that a pure market economy is not powerful enough to attain the major economic objectives like full employment, price stability, and a satisfactory rate of economic growth. The role of the government is to accelerate economic development and to distribute equitably the fruits of development among the various groups of society. This role is more dynamic and more aggressive in developing countries.

FISCAL POLICY OBJECTIVES

- Provision for social goods- Equitable distribution of wealth and income- Maintain high employment

- Ensure price stability- Sustain a satisfactory rate of economic growth

In the Philippines, the Six-Year Development Plan intends to use a large portion of the national resources for social services, like public education, health, nutrition, housing, national defense, social security, and the administration of justice, mostly for the benefits of the lower-income groups. Progressive taxation and the construction of rural infrastructures, among other things, are to be pursued to widen the sharing of the fruits of development.

FISCAL EFFECTS ON THE ECONOMY

Fiscal policy through its fiscal tools like taxation and government envisions to perform its functions of a location, distribution and stabilization in the economy. Proper measures on taxation and government expenditures can stimulate savings, investments, employment, production, and income. These can also help redistribute wealth and income and achieve price stability.

Individuals can save more, for instance, if prices are lower, if incomes are higher or if taxes are lower. Higher taxes do not only decrease the disposable income of people but also increase the cost of production. As a result, producers and sellers increase the cost of production. As a result, producers and sellers increase the prices of their goods. When prices are higher and incomes are lower because of the increase in taxes, the purchasing power of the people decreases. This affects adversely their consumption and savings. They have less consumption and less savings. When there is a decrease in consumption, investment and production also decrease. And when savings decrease, funds that can be used for investments also decrease. Clearly, all these negative economic implications are disastrous to the well-being of the poor people and the whole economy. These bad conditions of the economy started only from one source – the increase of taxes. Hence, the indiscriminate use of tax measures should be avoided.

ENCOURAGE INVESTMENTS

The government can encourage investments by giving tax exemptions or reasonable taxes, and by extending the necessary external economies of scale like transportation, communication, electrification, and peace and order. All these benefits reduce the cost of production of businessmen, and therefore, they have a greater chance of getting better returns or profits of their investments.

More investments mean more employments, production, incomes, consumption, and savings. For instance, when more businessmen put up more factories and supermarkets, workers and employees are needed. More employment results to more production of goods

and services and generates more incomes. When people have more money, they naturally buy more goods and services. This further accelerates more investments, production and incomes. Eventually, these lead to higher economic growth for the whole economy and higher standard of living for the people. And these have been made possible by fiscal policy tools like tax incentives and government expenditures on the external economies of scale.

REDISTRIBUTION OF WEALTH AND INCOME

Another function of fiscal policy is to redistribute wealth and income fairly among the various groups of society. The government can attain this through appropriate fiscal programs like agrarian reform program, cooperatives development program, housing, education, and health programs.

The aforementioned projects or programs provide social goods and services to the poor. For instance, tenants have been given lands to cultivate on an easy-installment basis. The low-income groups can acquire housing units at a very low price. Children of the poor can study in public elementary schools for free. The poor who are sick can go to government clinics and hospitals whose services are free. In more progressive countries, many of the basic needs of the very poor are given free by the government. There are also pensions for the aged and salaries for the unemployed.

Such social welfare programs are funded by taxes paid by the people. Based on the principle of ability to pay, the more fortunates pay higher taxes. Yet, they seldom or do not patronize at all government hospitals, public school, housing projects and other social welfare programs. On the other hand, the poor who pay very little taxes or none at all are the main beneficiaries of the government social welfare programs. Thus, a part of the resources of the rich and other high-income groups are extended to the poor.

WEAKNESS OF FISCAL POLICY

Fiscal-policy making is more of a political rather than a market process. Many and varied interests do influence fiscal policy making. In general, some of the popular interests are those of the voters, business group, farmers group, workers group, and other special groups. Needless to say that a good fiscal policy is more concerned about social justice and the equitable distribution of the social and economic resources of society. It should benefit the greatest good of the greatest number of the population.

It is the assemblymen (congressmen and senators) who introduce and decide tax and expenditure measures. Every assemblyman has his own project in his own political territory. However, it is not possible to accommodate all the projects of the assemblymen due to limited funds. Hence, these are prioritized. But, in practice this is not always followed. The more

powerful and influential lawmakers get more projects. During the old society, congressmen and senators who belonged to the minority party got the remnants of the budget. And so they could not put up impressive or big projects to satisfy the people in their territories. Another bad political practice of some congressmen and other politicians was that they did not give projects to the places where they lost in the last election. On the other hand, groups who could ensure the victory of politicians were favoured more by fiscal policies. Such situation also happens in the developed countries like the United States. Nevertheless, the aforesaid bad political practices are more rampant in the less developed countries where personal interests have the upper hand, and where corruption is more widespread.

BOOMS AND LAGS

Another weakness of a fiscal policy happens during a period of boom. Under such condition, the proper fiscal measures should be to increase taxes and/or decrease government expenditures. But in reality these are difficult to implement. Naturally, people will oppose the increase in taxes. Also, those who are affected by the decrease in government expenditures like in education, public health, and social security benefits will complain. It is hard for most people to understand that such fiscal measures are needed to reduce economic instability. They are more aware of the direct and short run effects on their welfare. Thus, for political expediency, such fiscal measures are not likely to be adopted.

Also, like monetary policy, fiscal policy suffers a lag. This involves the discussions of the problem, the implementation of the appropriate fiscal policy, and its subsequent effects on the economy. The whole process usually takes longer delays than that of monetary policy. It is possible that the nature of the economic problem has already changed by the time the fiscal policy is to be implemented. Thus, the policy is no longer the right solution to the problem.

OTHER SHORTCOMINGS

The ability of a country to finance its various programs and projects depends on its available resources and borrowings. Such resources come mostly from taxes, and these are not enough to fund even the most essential projects. In less developed countries, government income from taxes is low. Many are not employed and those who are employed have low wages. The few who have the ability to pay higher taxes do not pay correctly. Such conditions contribute to the poor revenue collections of the government. Clearly, these are not enough to support the social economic needs of the people. The last option is to encourage foreign investments and acquire more foreign loans.

Many economists have observed that the tax administration in many less developed countries is not only inefficient but also corrupt. The big shots, both foreigners and local elite,

do not pay the right taxes because of their connections. They either bribe the tax collectors or the top tax officials. Professor Kaldor said some years ago:

In many underdeveloped countries, the low revenue yield of taxation can only be attributed to the fact that the tax provisions are not properly enforced, either on account of the inability of the administration to cope with them or on account of straightforward corruption . . . an efficient administration consisting of persons of high integrity is usually the most important requirement for obtaining maximum revenue . . . (Todaro, 1977).

DOMINANCE OF INDIRECT TAXES

Another defect of taxation in the less developed countries is that most of the tax revenues are indirect taxes. These are taxes on goods but businessmen pass them on to the buyers by raising the prices of their goods. Examples are sales tax, specific taxes, amusement taxes, and custom duties. So, it is actually the buyers who pay the taxes.

In less developed countries, most of the people are poor. They become poorer because of indirect taxes. Every time they buy a basic commodity like notebooks, clothings or housing materials, they pay taxes. Since most of the revenues of the government come from such taxes, it is the poor who really finance the programs of the government like schools, hospitals, housing, etc.

Some giant business corporations take pride in announcing to the public that they have paid millions of pesos as tax payments to the government. But where did they get these? Such big amount of taxes actually came from the buyers of their goods. Whenever the government increases the taxes of certain goods and services, their price also go up. Thus, the burden of sacrifice is being carried by the buyers. Since most of the consumers are poor, it is this group who suffers the most.

COORDINATION BETWEEN MONETARY AND FISCAL POLICY

Both the monetary and fiscal policies have the same objective – the attainment of greater economic growth. Hence, there is a need for cooperation and coordination between the two. For instance, in times of inflation the job of monetary policy is to contract money supply while that of fiscal policy is to eliminate useless government expenditures. During a period of great depression, monetary policy is weak. On the other hand fiscal policy is more effective in solving the problem. To fight depression, the government undertakes massive government expenditures on public works to generate employment and income. This means consumption of goods and service will increase and so with production. However, fiscal policy is quite helpless in a period of boom. Under such condition, the proper weapon to combat the

problem is monetary policy. It increases interest rates, reserve requirements and controls credit. Such policy instruments regulate unnecessary consumption, and may stimulate savings.